Why Active Investment Management is a Zero Sum Game

There have been some negative headlines in the press recently criticising investment fund managers of underperforming their relevant benchmarks.  These results were highlighted in the most recent S&P Global annual scorecard which tracks the performance of almost 1,000 actively managed funds versus their benchmark index.  An index is simply a way of tracking a number of investments in a particular class as a whole, such as Australian shares.  For example, the All Ordinaries measures the performance of the top 500 shares on the Australian Stock Exchange.  The Dow Jones Industrial Average tracks 30 of the most influential US companies traded on the New York Stock Exchange.

sp-asx-20

What is active funds management?

In the world of investing, an active fund manager employs a team of people to carefully analyse the market and make trades to deliver an investment return that hopefully exceeds what you could have achieved, had you merely invested in the benchmark index.  As you can appreciate this is quite a complex job and the fund manager charges a management fee to be remunerated for their skill and expertise.  This style of investing is called ‘active investing’.  The alternative, ‘passive investing’, refers to simply purchasing a more economical index fund and accepting the overall risk and return of the market.

Active investing rarely pays off

The theory behind active investing is that you pay experts (such as a fund manager or stock broker) to do the complex investing for you, so that after all fees and costs you’ll be better off in the long run.  Does it work?  Of course it works!  Do the same active fund managers consistently outperform their benchmark indices?  Usually never.  According to S&P Global, Australian active managers are under-performing their benchmarks more often than not over 1, 3 and 5 year periods.  In similar reports from Europe, 86% of active funds managers have not outperformed their benchmark in the past 10 years.  This is not dissimilar to results in the US and UK.

Warren Buffett bets index funds outperform active management

warren-buffett

Warren Buffett

Widely respected investment guru, Warren Buffett has been critical of the active funds management industry, arguing that they don’t add value to client’s portfolios.  Knowing that the heirs of his estate won’t have his unique ability to manage investments, he has instructed the money to be invested in index funds.  In fact, he believes in the process so much that in 2008 he made a bet with a US hedge fund that the S&P 500 index would outperform one of their hand-picked portfolio of funds.  While there has been some lead changes since starting, after 8 years, Buffett remains ahead.  Whether he wins in the end is not the point.  The point is that active funds management is a zero sum game.  While you may get lucky at some point, it is near impossible to consistently pick winners.

Benefits of index investing

Index investments are not as sexy as actively managed funds but they have some compelling benefits which are very hard to ignore:

  • Greater diversification – performance risk is spread across many more underlying investments
  • They have much lower associated costs than actively managed investments – while nobody can guarantee investment returns, a lower cost investment already puts you ahead
  • No key person risk – index funds run relatively simple processes that are not reliant on one key person or team of people with valuable intellectual property
  • Index funds are highly liquid – there is no risk of funds being ‘frozen’ in the event of a crisis
  • They never under-perform their benchmark – they are the benchmark!

We are strong advocates of index investing and have used this method to construct all of our client portfolios since day one.

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